Energized Portfolios

LIFTED BY RISING OIL PRICES, mutual funds specializing in energy stocks have had a terrific year. Morningstar's specialty natural-resources fund category had gained more than 15% through Thursday, versus 1.04% for the Standard & Poor's 500.

Even Bill Miller, the longtime manager of
Legg Mason Value Trust,
who for the most part has shunned energy issues, admitted in a recent letter to his shareholders that these stocks are now worth considering.

As expected, plenty of cash has poured into this fund sector. In July, natural-resources funds took in $800 million, the 12th consecutive month of net inflows, according to Financial Research Corp. Technology funds, which have suffered from poor performance this year, had outflows of $556 million in July. These funds have had net outflows in eight of the past 12 months.

"My main concern is about investors chasing a hot sector," observes Sonya Morris, a fund analyst at Morningstar. "Speculators have been bidding up the price of oil, and it remains to be seen how sustainable that is."

Meanwhile, a handful of energy-fund managers offer divergent views on the sector. J.C. Waller, who runs the
Icon Energy
Fund, unable to find a lot of value right now, is taking a cautious view. Last November, by Waller's calculations, the energy sector traded at a 25% discount to its intrinsic value. But the gap has narrowed considerably since then, he says.

As a result, Waller has raised his cash position to 15% of the portfolio, which is fairly concentrated, with 51 stocks.

The fund is up 22.48% this year, placing it in the top 21% of its Morningstar category. "There have been certain industry groups that have been bargains, and we've been right," he says, adding, "So far, so good."

He has overweighted the portfolio in refining and marketing firms -- along with equipment and service companies. Waller doesn't own
Exxon Mobil,
for the most part preferring smaller companies. Holdings include an independent oil and gas company, Ultra Petroleum, whose shares have climbed nearly 80% this year.

Frederick Sturm, portfolio manager of the
Ivy Global Natural Resources
Fund, is upbeat about the industry's prospects. "Far too many people are trying to figure out what the last chapter of the oil story is going to be," says Sturm, whose fund is up 12.58% in 2004. "I think we are but several chapters into what will be an extended energy story for more than a dozen years."

In Sturm's view, even if oil prices drop below $40 a barrel -- say, to the mid- to-high 30 range -- drillers' stocks could still move higher. Why? Because with prices in that general range, plenty of companies would look for oil, he says. Many companies, he says, "have been very hesitant in going out and spending the money and cash flows." Sturm believes crude prices can't slip below $28 a barrel: "Any price sustained below that level would likely cause capital to exit the sector," he says.

One company Sturm favors is
Precision Drilling,
based in Calgary. Its shares have appreciated nearly 20% since early June. He has avoided the integrated majors, partly because their "production growth rates are very modest." "With oil prices coming down, we don't see any growth from the pricing side," Sturm adds.

Still, he predicts that oil prices will stay high enough to create strong opportunities for coal as an alternative energy source. The fund's holdings include
Peabody Energy,
which has substantial holdings in coal operations around the United States; its shares have climbed about 30% this year.

Unpleasant Surprise

John Montgomery, the top executive and a portfolio manager at Bridgeway Capital Management in Houston, has cultivated an image of probity. An outspoken critic of fund advisers who use soft-dollar arrangements, in which they receive research or other services in return for steering trading commissions, Montgomery has emphasized the importance of fiduciary responsibility. All of this made him a favorite in the financial press, including Barron's, after the fund scandals hit a year ago.

His themes resonated.

That's why it was so surprising when word came last week that Montgomery and his firm had reached a settlement with the Securities and Exchange Commission stemming from overcharging shareholders in three funds.

The no-load firm operates 11 retail funds with about $1.5 billion in assets.

The overcharges, which resulted from performance-based fees, occurred in three funds: Aggressive Investors 1 (whose shareholders were overcharged nearly $4 million), Aggressive Investors 2 ($110,365) and Micro-Cap Limited ($307,989). Montgomery is the portfolio manager of each of them.

As explained by the SEC, fund managers must calculate performance-based fees using the average value of the fund's assets over the same period used to measure the fund's performance, in this case five years. Bridgeway, however, calculated its performance-based fees by using the funds' current asset values, not the average values over the five-year period. Result: higher performance-based fees.

The base management fee, set at 0.90%, rises as high as 1.60% or falls as low as 0.20%, depending on how well the funds perform over the previous five years.

Under the settlement, Bridgeway will give affected shareholders $4,407,700, plus interest of $458,764. In addition, Bridgeway will pay a $200,000 penalty, and Montgomery will pay $50,000.

Montgomery wouldn't comment. But on the firm's Website, he writes, "Plain and simple, we broke the Rule, which is the same as the underlying law. We believe that breaking any law is serious. The consequences of the settlement of the charges will affect the shareholders, the Adviser and me."

He says squarely, "I am the one at fault." He points out that the firm has hired a new compliance officer and that its board has hired a law firm for "more depth on both the legal and compliance sides of our business."

Analyst Bridget B. Hughes, in a note on Morningstar's Website, calls the incident disappointing. "Montgomery and his staff owe it to shareholders to be intimately familiar with the laws governing mutual funds, and in this case, they simply failed -- even though the adviser's calculation has been disclosed in prospectuses since they began," Hughes observes.

The offense, she says, reflects "the operational risk that smaller shops like Bridgeway face in trying to comply with an increasingly daunting regulatory climate."

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